Why Health Care Costs Exploded After World War II

[Editor's Note: This Q & A with Dr. Michel Accad, M.D. on the economic history of modern medicine covers the Great Depression to modern times. Part 1 covers the "pre-Flexner era" to the Great Depression.]

Q: What alternative models of health care payment were sought during the Great Depression?

A: Taken aback by the sudden surplus of hospital beds, and realizing that patients and families were not willing or able to use hospital services at the prices demanded, leaders of hospital associations and of medical associations, such as the American College of Surgeons, began to look for models of collective health care payment.

They remarked that European countries which had adopted government-funded health plans did not seem to have the same problem of surplus capacity. The apparent ability of European systems to coordinate supply and demand reinforced the belief of these American leaders that a similar plan would be desirable for the United States. But political opposition to a national health care system was strong, and the medical community itself was divided on this idea.

Q: Why didn’t private insurance companies step in?

A: Commercial life and casualty insurance companies had been very reluctant to enter the health care business for fear of adverse selection (sicker patients, rather than healthy ones, buying insurance products) or moral hazard (people increasing their use of services once insured). Screening against adverse selection did not seem practical, and methods to control moral hazard were of uncertain effectiveness.

Q: How were these obstacles overcome?

A: The details of the birth of health insurance are very complex. Some proposals and experiments had taken place on a small scale before the Great Depression, but during the 1930s the efforts intensified.

The most famous early experiment was an arrangement between a Dallas hospital and the city’s teachers. A prepayment plan was devised by which the hospital would receive fixed monthly subscriptions in exchange for which it would provide hospital care at no charge. The experiment seemed to be successful and showed that the question of adverse selection could be dealt with by limiting the offer of insurance products to employed persons.

Out of that experiment, more complex arrangements grew. These arrangements attracted the attention of the nation’s health care leaders, such as those involved in the CCMC who, as we saw earlier, thought that the problem of health care was “not the system, but a lack of system.”1

The managerial problems confronting the insurers were innumerable and the uncertainties great. Much of the business had to be learned by trial and error and the initial efforts seemed at times perilous. In the days of the Great Depression, however, these attempts at organizing the financing of health care benefited from operating costs that were stable or even falling, and by a population that had now gotten into the habit of restraining its health expenditures.

The main boost to the health insurance industry, though, came from new legislation and administrative rulings.

Q: What were these enabling legislations?

A: State-level legislations were passed to allow pre-payment plans, such as Blue Cross and Blue Shield programs, to obtain non-profit, tax-exempt status and to offer insurance coverage without the reserve requirements imposed on commercial insurance companies. New York was the first state to pass such legislation, and forty others followed suit.2 Without these laws, the Blues would never have been able to operate on the scale that they did.

More importantly, insurance programs benefited greatly from the federal Stabilization Act of 1942 which allowed companies facing scarce labor (during a time of price and wage control) to compete for this labor by offering health insurance benefits and by making those benefits exempt from payroll taxes.

There were also rulings preventing employers from canceling or modifying group insurance during the contract period, and rulings that established health benefits as wages, allowing labor unions to negotiate for the provision of health insurance on behalf of employees.

With these successive legislations and rulings, commercial insurance entered the health care market more willingly and employers began to offer health insurance to employees on a very large scale. Between 1940 and 1950, the number of people with health insurance grew from less than 10 million to over 80 million Americans.

Q: What were the economic consequences of the introduction of health insurance?

A: The return of medical price inflation. When the economy began to grow after the war, health care utilization and health care costs again increased, rapidly outpacing the increase in the general price level.

Q: What was the increase in medical prices attributed to?

A: Once again, the increase in prices was attributed mostly to scientific and technological advances, the same error in judgment that had been made during the medical price inflation of the 1920s, as we saw previously.

Q: What were the real reasons for the return of medical price inflation?

A: Undoubtedly, moral hazard (the tendency for insured persons to utilize medical services more than they would if they did not have insurance) must have played a major role. For a long time, economists ignored or minimized the effect of moral hazard in health insurance. It is only in 1963 that the idea was entertained seriously for the first time by Kenneth Arrow, a major economist and future Nobel Prize winner. Arrow, however, did not speculate on the importance of moral hazard in health insurance but left the question open-ended.

Q: Why was moral hazard ignored?

A: One factor that may have played a role is that modern mainstream economics had become a highly empirical enterprise. To this day, most economists are reluctant to defend economic propositions unless these can be backed up by empirical data.

Empirical data were unavailable to support or refute the role of moral hazard in medical price inflation for a long time. Today, however, the role of moral hazard is increasingly recognized both theoretically and on empirical grounds.3

Another reason may be that many academics and health care leaders found the idea of health insurance so appealing as to have a bias blinding them to the negative impact of moral hazard. Kenneth Arrow, for example, stated that:

The welfare case for insurance policies of all sorts is overwhelming. It follows that the government should undertake insurance in those cases where this market, for whatever reasons, has failed to emerge.

With such a strong positive opinion about the social value of insurance, it is not surprising that its harm would tend to be minimized. Highlighting the danger might have discouraged government from entering the insurance business.

Another important reason is that there are two aspects to moral hazard that are at play in health care. These are not always well recognized or distinguished.

Q: What are the two aspects of moral hazard?

A: The first one, which matches the negative connotation of the term, is the aspect imported from other insurance settings. For example, in the case of car insurance, the term moral hazard refers to the fact that someone with car insurance might drive less carefully than someone without coverage. In a way, that person may be “taking advantage” of the insurance company.

In health care, that aspect of moral hazard probably exists, but may not be very important. For example, it’s conceivable that people who have insurance are more likely to engage in more dangerous sports activity. But this kind of moral hazard can probably be accounted for by the insurer and be factored into the actuarial analysis to determine premium prices.

The other aspect of moral hazard stems from the fact that every single medical encounter or medical act can be said to be ordered toward the preservation of life or toward the well-being of the person.This by itself presents a strong incentive to use medical services, and the behavior should not have the same negative connotation as in the first aspect of moral hazard. In fact, economist John Nyman has argued that the behavior by which insured people would use more health care is a social good.

The bottom line is that one does not need to be sick to utilize medical services and that all that is needed is a plausible argument that if a medical action is taken, life may be prolonged or enhanced. Such plausible arguments are not hard to come by, especially in a health care system where doctors and hospitals are largely paid on a fee-for-service basis. There is no objective limit on what can be considered “desirable care,” and if cost is not a consideration, more medical actions will be taken.

Q: Demand curves slope downward?

A: Yes, even in health care…

Q: What other factors could have played a role in medical price inflation?

A: Some other factors might have increased demand for medical care to some extent. For example, after the war, there was a large increase in government funding for medical research and development, and this investment was accompanied by well-funded public-private “awareness campaigns” aimed at combating this or that condition.

Disease awareness campaigns, increased attention to personal risk (in a now more affluent society), and general optimism regarding the effectiveness of new medical advances are all factors which probably contributed to increasing demand for medical services, but the main factor was that a large number of patients and health care “consumers” were now shielded from costs.

Q: What about the educational and licensing restrictions you mentioned last time?

A: Of course, licensing and regulatory restrictions were still operational in limiting the supply side of health care. Licensing requirements were expanded to hospitals and would later be intensified on the pharmaceutical industry, adding to the costs of medical care. The proportional effect of each factor on costs is difficult to measure properly. I suspect that these factors are small compared to the increased utilization due to moral hazard.

Q: Didn’t the rising utilization hurt the insurance industry?

A: To the extent that it did, insurance companies were able to make up for it by increasing premiums, especially as they came to anticipate increased utilization. In fact, the increase in premiums have largely outpaced the general inflation level ever since the 1950s, and perhaps even earlier.

The increased utilization of medical services, however, did force the Blues to abandon the pre-payment model and adopt arrangements similar to those offered by commercial insurance companies.

Q: Didn’t the increasing cost of insurance hurt employers?

A: To the extent that it did, there was not much employers could do about it. With rising medical prices, the need to have health insurance would become more and more acute. Employee discontent would have been too great to abandon health insurance as a benefit. Executives themselves also benefited from the group rate, so the idea that health insurance should be abandoned could not be entertained seriously.

Q: People were hooked!

A: Health insurance is a seriously addictive and harmful social drug.

Q: The harm, of course, is not borne by the policy holders.

A: Precisely. The rising prices generated by health insurance affect those who are not covered. In the 1950s and early 1960s the financial threat of illness was very serious for poor people and for the elderly.

Q: How was the situation addressed?

A: With the enactment of Medicare and Medicaid in 1965. The government provided generous health insurance benefits to the most politically influential class, the elderly, which also happens to be the class whose needs for medical care are naturally the highest.

The terms of Medicare insurance were also very generous to physicians and hospitals since, to secure their cooperation, the government decided to pay them their “usual and customary rate,” which means that, for a time, the government had no way of controlling costs.

Q: I can see things spiraling out of control…

A: As a matter of fact, once Medicare was introduced, medical prices became completely “unhinged.” Within a few years, Medicare expenditures were quadruple what had been anticipated.

The demand for medical services was so high there was an acute shortage of doctors. Immigration laws were adjusted to allow a rapid influx of physicians from abroad. There was a boom in hospital construction. Incredible facilities and health care complexes were built.

Naturally, with skyrocketing medical prices, insurance premiums had to increase correspondingly. This began to really affect employers.

Q: I have a feeling the party would not last forever?

A: You are correct, but reining in out-of-control costs would not be an easy task.

Beginning in the 1970s the concept of “managed care” was introduced in academic circles to provide the government and the insurance industry some models with which they might begin to get things under control.

From then on, and to this day, the screws have been increasingly tightened on the health care community: price controls, bureaucratic demands, technological impositions, and pay-for-performance schemes.

In response, physicians and hospitals have taken steps to minimize the financial impact by merging into larger and larger groups, by increasing the volume of patients seen, by reducing hospital length of stay, etc.

Q: Have the measures to control costs been successful?

A: Have you tried to purchase medical services lately?

The efforts to rein in costs have been largely ineffective. On the other hand, they have introduced all kinds of health care distortions because the screws are not applied evenly but according to political and bureaucratic considerations.

Whatever differences of opinion people may have about health care today, there is widespread agreement that the quality of the medical experience for physicians, health care staff, and patients, is poor and getting worse.

Q: Where are we now?

A: The latest phase in this drama has been to try to expand health insurance to make it available to everyone. Coupled with this effort are continued attempts to come up with a “better system.” Accountable care organizations are the new hope, along with other schemes where the financial risk is passed down to those providing the care.

Importantly, a “cultural revolution” is taking place, or at least attempted. This cultural revolution promotes a new doctrine of “less is more,” a generally pessimistic outlook on health care utilization which in stark contrast with the optimistic and perhaps hubristic mood displayed during the first 100 years of the health care system. Moreover, a new medical ethics is advanced that aims to replace the physician-patient dyad with a triad that includes the collectivity.

1. Many of the leaders of the CCMC and of its supportive organizations became involved early on in the development of the Blue Cross and Blue Shield organizations. Examples include Ray Lyman Wilbur, chairman of the CCMC and C. Rufus Rorem, one of the main authors of the CCMC report. Wilbur was at one point chairman of the California Blue Shield and lobbied hard within the AMA to remove any opposition to the development of an organized, pre-paid health care system. Rorem played a very important leadership role at both Blue Cross and Blue Shield nationwide and was also a leader at the American Hospital Association (AHA), a co-sponsor of the CCMC.

2. In exchange for the tax-exempt benefit, the Blues had to set premiums according to “community ratings,” an important restrictions that would later force the Blues to abandon their pre-payment model. The first such state law was enacted in New York with the help of Louis H. Pink, then superintendent for insurance. Pink was a committed social reformer whose name is now associated with an notorious housing project in Brooklyn he helped establish.

3. We would have to wait until the 1970s for a first study to be conducted to address that question, the RAND health insurance experiment. Its conclusions were very tentative, suggesting that if moral hazard played a role in health care utilization, it’s role was modest. To this day, many mainstream economists discount the notion that moral hazard is an important factor, but recent studies, in particular works by MIT economist Amy Finkelstein, are finally making a much stronger empirical case to highlight the importance of moral hazard.

Michel Accad, MD, practices cardiology and internal medicine in San Francisco, offering individualized care in a free-market setting. His blog about health care and medicine is AlertandOriented.com. He also co-hosts the Accad And Koa Report podcast.